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Key Considerations in Preparing to Raise Private Capital

06.16.2016

For startups and small businesses considering raising outside capital, there are certain issues that get much of the focus and attention, such as a company’s valuation, investor pitch deck, and term sheet. Before a company tackles these aspects of raising capital, however, there are many housekeeping matters that it should assess in order to take full advantage of its capital-raising opportunities. This article provides an overview of some of the key considerations in preparing to raise private capital.

Securities Laws

When a company raises equity capital, it sells a security. And, every time a security is sold, it either must be registered with the Securities and Exchange Commission, and applicable state law, or be exempt from registration. Capital raises for startups and small businesses are most often structured as private offerings that are exempt from registration. The ins and outs of how to structure an exempt offering are beyond the scope of this article and should be discussed with a securities lawyer at the time of the offering; however, before an offering begins, a company needs to be aware of the securities laws’ limitations on public communication. Although the Jumpstart Our Business Startups (JOBS) Act, signed into law in 2012, greatly reduced these limitations, a company that publicly advertises or otherwise generally speaks of its potential capital raise risks running afoul of the securities law exemption on which it otherwise could have relied. Accordingly, all proposed statements and materials regarding the capital raise should be first reviewed by counsel.

Formation and Founder Issues

When initially formed, most startups and small businesses are limited liability companies or S corporations, and are organized in the company’s home state. These structures are the most flexible, cost effective, and tax efficient. Some investors (particularly venture capital and angel investors), however, prefer to invest in C-corporations, and almost all professional or institutional investors prefer their portfolio companies to be organized under Delaware law. Before seeking outside capital, a company should review its entity form and state of organization and discuss with its legal and tax advisors whether modifications can and should be made to make the company a more attractive target for investment.

In addition, a company should review its organizational documents (e.g., certificate and operating agreement, or charter and bylaws) to confirm that such agreements are in force and effect. A company should also work with counsel to ensure that corporate formalities for material company activities, such as proper appointment of directors and officers, have been followed. Addressing these issues prior to a capital raise will avoid delays and investor red flags.

Lastly, one of the most critical issues for investors is confirming that a company’s ownership structure is clear and properly documented. There is no bigger red flag to prospective investors than discovering a long-lost co-founder that left before proper paper was in place. Accordingly, a company should identify and address any gaps in their capitalization table before investors are in the mix (and dollar signs are in the former founder’s eyes).

Approvals

In order to properly authorize and issue new equity, a company will need to obtain approval from its governing body (e.g., board, manager) and potentially its existing equityholders. Moreover, existing equityholders often have certain rights, such as a pre-emptive right to participate in future equity rounds, that need to be reviewed and addressed, either by way of complying with, or obtaining a waiver of, such provisions.

A company should also review its material contracts to confirm if any third party consents or notices may be required for ownership changes. Bank financing documents and real estate leases, in particular, often contain such requirements.

Employees and Intellectual Property

Technology or other proprietary know-how is often critical to the success of many startups and small businesses. Accordingly, investors will want to ensure that a company has adequately protected its intellectual property. An upcoming capital raise is a good opportunity for a company to confirm that it has a confidentiality and invention assignment agreement in place with all employees and contractors that makes it clear that any intellectual property created by the employee or contractor belongs to the company, and not the individual. In addition, a technology-driven company should review its intellectual property portfolio with counsel to determine if any actions should be taken to strengthen or expand its trademarks, copyrights, patents, or licenses.

Financial Statements and Insurance

Another way for a company to instill confidence in potential investors, and to maximize its capital raising opportunities, is to ensure its financial house is in order, including by having professionally prepared financial statements and maintaining adequate insurance coverage. A company preparing for a capital raise should review these items and address any inadequacies or gaps in coverage.

Companies also often consider whether to prepare financial projections ahead of a capital raise. Due to potential anti-fraud liability under the securities laws, legal counsel will prefer that a company not provide financial projections; however, the reality is that prospective investors often require such projections. If such projections are used, counsel should be involved in the preparation and review process to try and mitigate the risk.

Conclusion

A successful capital raise will ultimately be driven by the quality of the business and its leadership team. As discussed above, however, there are numerous (and often fairly simple) steps a company can take prior to seeking outside capital that can help the company maximize its capital raise opportunities.